Levelized Costs and Net Present Value

Economic forecasts used by government estimate the costs and benefits over the lifetime of a project, and usually involve hidden assumptions about the value of costs and benefits in the future relative to the costs and benefits in the present. The basic assumption is that we would rather pay more for something in the future, and less now. That may be consistent with most human psychology and investors’ approaches to taking risks, BUT is likely to be inappropriate when we are facing climate change, and a future where the resources we need to build our new energy system are likely to become more scarce.

The outcome of these calculations can be a ‘Cost Benefit Analysis’; a ‘Net Present Value’ or a ‘Levelized cost’ (defined below). The reduced value of the future relative to the present is called the ‘discount rate’. 

This may seem like a niche issue, but the choice of discount rate can be decisive in whether renewable energy is considered cost-effective relative to fossil fuel power stations. It is particularly insidious because the assumptions about discount rates are hidden to most people, and are accepted without question by most people who use them. The reason for using a discount rate is not usually examined, but there are actually several different meanings which are appropriate in different settings, and have deep social implications.

Net Present Value

The net present value is the total discounted benefit minus the total discounted cost of an investment. This means that the costs and benefits in each future year are discounted according to the discount rate, so future costs and benefits are smaller in the overall calculation than immediate costs and benefits. This is typically presented as an overall value for an investment – e.g. the Net Present Value of a new wind turbine is £xx million.

Levelized Cost of energy

The levelized cost of something is the discounted cost per unit of energy.   

Cost-benefit analysis

An assessment methodology used by civil servants to assess whether a proposed policy should be implemented. This approach was instigated by the Blair government during 1997-2007. It involves calculating all of the costs and benefits of the policy, according to a specified set of assumptions and methodology. The output of the cost benefit analysis is the ‘Net Present Value’. If this is positive, the policy should be implemented. If negative, it should not.

Discount rate as cost of capital

The most ‘surface level’ meaning of discount rate is a proxy for the cost of capital. This is the money paid to investors in order to access the capital they provide to a project. 

In practice, investors make decisions based on projections of how much profit a project will make. The more risky the project is, the higher the return that the investor expects. This means that for a high risk project, the cost of capital is higher than for a low risk project. The investor takes the hit if the project doesn’t make as much money as expected, but they take a risk because the gain for them could be high. The minimum return required by investors is called the ‘hurdle rate’.

Typically in 2019 the cost of capital for a ‘risky’ investment is around 12%, and for a ‘secure’ investment is around 3%. Investment decisions also depend on how quickly an investor expects to make their money back – venture capitalists are seeking payback periods of 3-7 years, whereas ‘patient’ investment from pensions funds can wait 40 years and government investment could in theory take place over even longer timescales. Community energy projects often make use of community investment – from the local community – and offer returns on investment to their member shareholders ranging from 3 to 7%. The cost of capital can be a significant component of the viability of a scheme.

Governments are able to raise capital at a much lower cost than private companies, because investors see governments of countries as reliable institutions that will exist and be able to raise funds long into the future. This ability to raise cheap capital, which is also available to local governments, is one of the arguments in favour of national/state ownership of and investment in infrastructure. Another is that governments are able to take a long view and to take into account positive externalities – e.g. government can invest in energy with better air quality impacts, as this reduces the healthcare bill to government. 

Discount rates as time-consideration

Discount rates can be used as a proxy for cost of capital, but conceptually there is a different basis when we are considering the right approach to investment at a societal scale. Fundamentally, discount rates are about how we value the future relative to the present. 

One component of the discount rate is the extent to which people would prefer to receive £10 now or e.g. £20 on a future date. One reason for this discounting is uncertainty about the future. This could be the equivalent of not investing in a pension because I assume I will be dead by the time I would start to claim it. This is called the pure time discount rate. In the context of climate change, the pure time discount rate, as described above, could be increased to infinity – if we believe that humans are facing inevitable extinction. 

A second part of the discount rate is to do with how well we expect to be doing in the future.  If I am poor now, but expect to be rich in the future, then £10 now will be worth more to me than £20 in the future. This is the equivalent of a young person choosing not to invest in a pension on the assumption that they will earn more at a later stage in their life, and so can start their pension fund in the future.  This applies at a macroeconomic scale in relation to economic growth – if we assume that the economy will grow in the future, then investing a pound now has a high cost, and paying more in the future has a lower cost. However, whether we consider economic growth to be a desirable outcome or not, climate change may affect it enough to slow, stop or reverse economic growth. This could mean that there is less money in the economy in the future, and so we had better invest the money we have now in order to prepare – or, in terms of the discount rate, we should use a negative discount rate in our cost benefit analysis. This argument was made by Sir Nicholas Stern in his 2006 review of the economics of climate change. 

Discount rate applied to Electricity Generation

The cost structure of fossil fuel power stations and renewable energy power stations is different. Crudely speaking, fossil fuel power stations are cheap to build, per MW, and are dominated by the cost of fuel. Renewable energy has a zero cost of fuel (sun and wind are free), but have a higher capital cost of infrastructure per MW. 

This means that when the costs are discounted, fossil fuel generation comes out looking better than renewable generation.

In future, this page may show a comparison of energy costs for different technologies, using different discount rates, including zero and negative discount rates which would be appropriate in an ’emergency’ scenario such as a climate emergency.